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National Institute of Economic and Social Research

Monday, 19 March 2012

Selling off the roads: it's all about pricing

The announcement that the government is considering "privatising" the national road network is potentially an important step that could deliver major economic and environmental benefits - benefits that go well beyond any benefit to the public finances. But whether those benefits are realised depends crucially on how "privatisation" actually works.

The key point is that "privatising" a service can give, in principle, result in two types of benefit:

competition to provide the service; in principle, allowing the most efficient (lowest cost and/or highest quality) provider to do so, benefiting consumers;

allowing market-based pricing for the service; so that both producers and consumers have the right incentives, the former to produce the products consumers want, and the latter to consume only products that they are willing to pay a market price for.

The problem is that in services that are a "natural monopoly" (either on a national basis, or locally) the latter benefits do not flow automatically from privatisation. So when a natural monopoly is privatised but the pricing structure is left unchanged, then the benefits are far from clear. And against the potential benefits of private provision must be weighed the costs; first, that private providers will generally demand a higher cost of capital than applies to the private sector; and second, and more seriously, that if there is a regulatory framework post-privatisation - and almost inevitably there has to be, otherwise the service would never have been public in the first place - the providers may game the system and find a way to extract supernormal profits at the expense of consumers.

Note that I don't mention the aspect of the announcement that has been most hyped; encouraging "sovereign wealth funds from countries such as China to lease roads in England". Not because I think there's anything wrong with the idea; but because if that's all the scheme does, without realising any of the benefits of competition, then it amounts simply to off-balance sheet financing, with no long-term gains either to taxpayers or drivers.

That is why it is rather worrying that - perhaps for understandable reasons - reporting of the proposals so far has focused on the financing model, rather than the potential benefits from introducing incentives in both production and consumption. Indeed, the proposals are being described as "modelled on the funding of the mains water and sewage network."

But this would be exactly the wrong model. Water supply is a classic natural monopoly, and the privatisation of the water industry (which I worked on as a junior Treasury official in the late 1980s) was far from an unmitigated success. Consumers ultimately benefited from increased efficiency and from greater capital investment than would otherwise have been (politically) possible. However, at the same time, the industry was privatised under an excessively lenient regulatory framework that clearly led to shareholders making very large excess profits at the expense of consumers. The overall balance sheet is ambiguous. (PFI deals, with a similar economic rationale, yielded similarly mixed results).

By contrast, the privatisation of BT was far more successful - it led in time to market-based pricing for almost all telecommunications services (including many that hadn't even been invented at the time of privatisation), with, ultimately, very substantial benefits to consumers.

The Treasury and the Department for Transport have been asked to review the options, but it appears that there are (broadly) two possible ways the government could go:

the first would simply be to sell off the road network (or some part of it), including responsibility for maintaining and improving it, in return for an income stream; perhaps by hypothecating some proportion of VED and/or fuel duty. As set out above, this might or might not yield net benefits; and we really wouldn't notice much difference any time soon, either in our roads or our pockets. Crucially, we'd have no incentive to change where and when we drove. We'd probably get somewhat better roads, more efficiently constructed, but we'd have to pay more, and some of the extra would go to shareholders;

the second would be to replace VED and (a proportion of) of fuel duty with road pricing, or to introduce road pricing at least for new and perhaps some existing roads, with the roads owned, operated and maintained by the private sector. The potential benefits here are much larger. Road pricing would be better not just for the government and the new owners of the road network, but also for consumers; those people who valued their journeys least would reduce their journeys on the most congested roads at the most congested times, making life easier for those who valued their journeys most. And the revenue raised would allow reduced prices (including taxes) for those who travelled least or imposed the fewest burdens of congestion on others. We'd definitely notice the difference, because we'd start paying for each journey rather than in one lump sum (VED) or just when filling up; and that would be precisely the point, because the benefits would come if and only if we actually changed our behaviour; and pricing would make us do that.

The first policy is primarily about changing financial flows (between government, taxpayers, drivers and shareholders), perhaps with some ultimate benefits and costs; the second is about changing incentives, and hence behaviour, for the better, in economic (and environmental) terms.

Of course, the policy direction implied by the second approach is not new; the key recommendation of the Eddington Report (2006) was:

"Policy should get the prices right (especially congestion pricing on the roads and environmental pricing across all modes)"

The potential benefits are very large; using the Department for Transport's model, the report modelled a specific scheme, and found the following:

"Provided it is well targeted, a national road pricing scheme of this type could reduce congestion by some 50 per cent below what it otherwise would be in 2025 and reduce the economic case for additional strategic road infrastructure by some 80 per cent. Benefits could total £28 billion a year in 2025, including £15 billion worth of GDP benefits. "

Unfortunately, it never happened. The government has another chance now to get it right; but they have to remember two things. First, the primary benefits here are about resource allocation, economic efficiency, and hence growth and jobs, not about reducing public expenditure; and second, it is markets and incentives, not private provision per se, that can deliver those benefits. Let's hope they are bold.

[Note: Tim Leunig of LSE is more sceptical than me about the potential benefits of road pricing, pointing out that much of the network is uncongested; and that where it is, in urban areas, prices would have to be very high to make a real difference. Tim makes some good points, but the potential benefits, even looking at a static analysis, still seem large; and if the regulatory framework were right - albeit a big if - I also think that over time there would be scope for some of the benefits of innovation we saw with telecoms]

2 comments:

I'm sure you are right that road pricing could encourage more efficient use of the roads, but this is true only to the extent that drivers can substitute one journey for another at a different time or by a different route. Many (most?) journeys cannot be substituted in this way since there is generally only one road between two given places and people often need to arrive at a certain time, say at work by 9am.

Where people cannot substitute their journeys road companies will be free to extract arbitrary amounts from drivers and in general companies will find it more profitable to concentrate on making as much as possible from these drivers while driving everyone else away.

It is not hard to see that this has already happened in many places with trains and with local bus services outside London. Let's concentrate on fixing our other failed transport systems before we throw roads the same way.

An excellent piece. Accepting Tim's point on the level of pricing required to reduce demand enough (e.g. on the A406 at 7.45 on a weekday), two things strike me.

First, the proposal outlined by the PM excludes charging for existing roads, which creates deeply unjust distributional effects for local users of those roads just upgraded (e.g. A3 Hindhead) versus those who would get future improvements (e.g. A14). This localised effect is likely to be very political.

Second, the evidence of the M6 Toll road suggests that the great British public actually value their time at a value close to zero - taking their chances on the M6 rather than paying a fiver for the 27 miles of toll road.

I suspect this means that there needs to be a national system or not one at all - and that Eddington-style road pricing is absolutely the right answer. Given that the PM has announced that he's prepared to be unpopular to do the right thing, this should be an interesting test of his political courage.